Macroeconomics Seminar - Marcus Hagedorn (University of Oslo)

Room 315, Level 3, FBE Building, 111 Barry Street, Carlton


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Yusuf Mercan

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Title: An Equilibrium Theory of Nominal Exchange Rates

Abstract: This paper proposes an equilibrium theory of nominal exchange rates, which offers a new perspective on several issues in open economy macroeconomics. The nominal exchange rate and portfolio choices are jointly determined in equilibrium, thus providing a new approach to overcoming the indeterminacy results in  Kareken & Wallace (1981). A distinctive feature of this theory is that the nominal exchange rate is determined in international financial markets in response to fundamental and policy shocks and that the real exchange rate then inherits its properties from the nominal exchange rate. The novel theory offers a different perspective on how international asset flows affect exchange rates, how a country can divorce itself from these flows and manage its exchange rate. The model also implies that a country with an exchange rate peg and free asset mobility faces a tetralemma and not a trilemma because it loses not only monetary policy independence but also fiscal policy independence. This suggests a new way to think about fiscal coordination in a monetary union as a response to asymmetric shocks. The theory also accounts for the co-movement of exchange rates and interest rate differentials in the data, for the Backus-Smith-Kollmann Consumption-Real Exchange Rate puzzle, and for the Mussa puzzle on the volatility of real and nominal exchange rates under freely floating and pegged exchange rate regimes.